Tax Court Disallows Losses from S Corp Transaction Due to Lack of Economic Substance

(Parker Tax Publishing September 2020)

The Tax Court held that a couple who transferred assets to an S corporation and then dissolved the S corporation a few weeks later after receiving a liquidating distribution could not take an ordinary loss deduction relating to the distribution and were liable for an accuracy-related penalty. The court found that the IRS properly disallowed the deduction on the grounds that the transactions generating the loss lacked economic substance, and the court upheld the imposition of an accuracy-related penalty because the couple did not act with reasonable cause and in good faith in preparing their return. Daichman v. Comm'r, T.C. Memo. 2020-126.

Background

Sean and Linda Daichman are a married couple from Texas. During 2009, Mr. Daichman was employed as vice president of BTEC Turbines LP. In 2009, Mr. Daichman received a salary of almost $700,000 from BTEC. On the recommendation of their investment broker, the Daichmans sought estate planning advice in 2009 from Richard Shanks, an attorney and CPA. In November 2009, the Daichmans and Shanks decided on a tax-planning strategy designed with a goal of eliminating income tax liability on Mr. Daichman's income.

The tax structure, which Shanks marketed to a number of his clients, involved organizing multiple new entities including an S corporation (Trading S Corp), a family limited partnership (Investment LP), and a family management trust. Under the structure, the Daichmans would contribute cash and marketable securities to Trading S Corp. Trading S Corp would then transfer those same assets to Investment LP in exchange for 98 percent ownership as a limited partner. The family management trust would be the general partner and hold the remaining 2 percent of the partnership interest. Trading S Corp would then be dissolved and the interest in Investment LP would be distributed to its shareholders, the Daichmans. The Daichmans would own the 98 percent interest in Investment LP, and Investment LP would own the assets that the Daichmans had contributed to the S corporation. Shanks' proposal suggested that the structure would offer asset protection and that the value of the distributed partnership interests for tax purposes would reflect a reduced value because of large discounts for lack of marketability and control. According to Shanks, the structure and the dissolution of the S corporation would generate a tax loss for the Daichmans to report on their individual return. The Daichmans executed these transactions in November 2009.

Mr. Daichman had limited personal investing experience before engaging in the transactions promoted by Shanks. He had done little to no research into the requirements of day trading, and his claimed motivation to begin day trading with the new entities that were formed under Shanks proposal was his observations of others who appeared successful, including his current BTEC business partner, who was also a client of Shanks. Mr. Daichman did not do any additional research regarding day trading requirements after he engaged Shanks to form Trading S Corp. After formation on November 23, 2009, and subsequent funding, Trading S Corp executed its first trading activity on December 9, 2009. It sold 19.165 shares of Fidelity Capital & Income for proceeds of $16. Trading S Corp executed its first day trade on December 10, when it purchased and sold 250 shares of Continental Airlines on the same day. Trading S Corp executed only 10 additional day trades during the remainder of its existence. In total, Trading S Corp bought $159,673 in securities and sold $158,204. In accordance with Shanks' plan, Trading S Corp was terminated effective December 31, 2009.

On the Daichmans' 2009 joint individual tax return, the couple claimed an ordinary loss deduction on Schedule E of $2,099,090 from Trading S Corp, resulting in zero tax liability.

The IRS audited the Daichmans' return and concluded that they were not entitled to the claimed loss deduction and that were liable for an accuracy-related penalty under Code Sec. 6662(a). The IRS determined that the transactions generating the reported loss lacked economic substance; that Trading S Corp was not a trade or business, and that the transaction was not entered into for profit, as required under Code Sec. 165(c); that the Daichmans failed to show they incurred a loss under Code Sec. 331 and Code Sec. 336; and that the Daichmans understated the value of the distributed assets. The IRS sent a notice of deficiency and the Daichmans took their case to the Tax Court.

The Daichmans contended that they organized Trading S Corp as a vehicle for Mr. Daichman to engage in day trading while still working at BTEC. They claimed that they transferred the cash and securities to Trading S Corp in order to finance the day trading activities and that the transfers of assets to Investment LP through Trading S Corp were for asset protection purposes. The Daichmans claimed that Mr. Daichman quickly realized that the demands of his business did not allow for a successful day trading operation, and he promptly abandoned the activity for

that reason. With regard to the accuracy-related penalty, the Daichmans contended that they had reasonable cause for the positions taken on their tax return because they relied on the competent advice of their advisers in determining how the transactions should be reporting and how the discounts should be applied.

Analysis

The Tax Court rejected the Daichmans' arguments and held that they were not entitled to the claimed loss deduction and were liable for the accuracy-related penalty. The Tax Court applied the Fifth Circuit test for economic substance, articulated in Klamath Strategic Investment Fund v. U.S., 2014 PTC 108 (5th Cir. 2014), under which a transaction is respected for tax purposes if it (1) has economic substance compelled by business or regulatory realities, (2) is imbued with tax-independent considerations, and (3) is not shaped totally by tax avoidance features.

The Tax Court found that the transactions failed the first element of the test because they did not alter the Daichmans' economic position in any way that affected objective economic reality. In the court's view, the transfers of assets were effectively a circular flow of funds among related entities used to generate an artificial tax loss to offset Mr. Daichman's 2009 income. The court found that the Daichmans had constant control over the assets and entities at all relevant times, and neither the contribution to Trading S Corp nor its dissolution affected their position or caused real dollars to meaningfully change hands. In the court's view, the form of their ownership of the assets may have changed, but the substance did not. Accordingly, the court held that the transactions lacked objective economic reality.

Although the failure to satisfy the first prong of the economic substance doctrine was sufficient to find a lack of economic substance, the court went on to address the remaining two prongs. With regard to the Daichmans' purported non-tax purpose of day trading, the court found that the Daichmans' actions were not consistent with that goal. The court noted that while Mr. Daichman had no experience in day trading, he conducted no prior research into the activity, did not consult any references, and did not otherwise seek advice before expending time and resources to establish Trading S Corp.

In addition, the court found that Mr. Daichman began taking steps to dissolve Trading S Corp on December 10, 2009, after Mr. Daichman had completed a single day trade. The court further noted that before Trading S Corp had engaged in any trading, Mr. Daichman caused the company to transfer nearly all of its assets to Investment LP, a newly formed company that never engaged in any business activity and otherwise held no assets. The court found that the transfers to Investment LP served no business purpose and offered no potential for profit. The court said that even if it were to accept the Daichmans' contention that the transfer of assets to Investment LP was for asset-protection purposes, such a goal was unrelated to Trading S Corp's purported business activity, and the Daichmans identified no business motive or profit potential for using Trading S Corp as a conduit for that transfer. The court concluded that the Daichmans intended from the beginning to organize and dissolve Trading S Corp within the same year to generate a loss in an effort to reduce their 2009 income tax liability.

The court upheld the imposition of accuracy-related penalty after finding that the Daichmans did not act in good faith. The court noted that Mr. Daichman was a sophisticated and experienced businessman, and found that the Daichmans knew from the start that Trading S Corp was not a bona fide business and that the transfers did not meaningfully change their ownership of the assets. The court concluded that the Daichmans' knowledge alone was sufficient to negate a reliance defense.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,710.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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